Financial Markets and Institutions (2-downloads)

2. Covenants to encourage desirable behavior.

Restrictive covenants can

encourage the borrower to engage in desirable activities that make it more

likely that the loan will be paid off. One restrictive covenant of this type

requires the breadwinner in a household to carry life insurance that pays off

the mortgage upon that person’s death. Restrictive covenants of this type

for businesses focus on encouraging the borrowing firm to keep its net worth

high because higher borrower net worth reduces moral hazard and makes it

less likely that the lender will suffer losses. These restrictive covenants typ-

ically specify that the firm must maintain minimum holdings of certain assets

relative to the firm’s size.